MEDIA CONTACT: Dr. Mike Walden, 919.515.4671 or michael_walden@ncsu.edu

YOU DECIDE:What's inflation's real cause?

By Dr. Mike Walden
North Carolina Cooperative Extension Service

Headlines announce that inflation is back, and this certainly appears to be accurate: 2004's retail prices rose 2.7 percent, up from 2.3 percent in 2003 and only 1.6 percent in 2002. But in 2005's first two months, the retail inflation rate is running at an annual rate of 4.8 percent.

The jump in inflation is not due to rising oil and gas prices alone. Even without considering rising food and energy prices, retail inflation climbed during the past two years.

Of course, any businessperson or store manager will point to inflation's source: rising costs of doing business. The restaurant owner cites higher food, labor and electricity costs; the builder argues he has to pay more for lumber, nails and drywall. And the painter says increased costs for paint, brushes and white shirts force her to charge more for painting services.

These experiences make it seem as if there are multiple causes of inflation, and from the point of view of individual companies, there are. But this still leaves a larger question unanswered: What gets the whole process started?

Economists have a simple answer: money! The economic workings of higher inflation really can't start without being prompted by too much money being available for people to spend.

Here's what I mean. Say the total quantity of everything we buy - cars, gas, dental services, clothes, etc. - increases 5 percent a year. Now say the money we have available to purchase these things also increases 5 percent each year. In this case, the increases in production and spending balance, and as a result, prices don't change, which is the same as saying there is no inflation.

But what if the available amount of money increases by 8 percent each year? This means people try to increase their products and services purchases by 8 percent, but the production of these products and services rises by only 5 percent. So people try to buy more than is available (economists say demand is increasing faster than supply), so something must give.

What gives is prices. Rather than remaining stable, they rise by the difference between spending growth (8 percent) and production growth (5 percent), which is 3 percent. So in our example, the inflation rate rises from 0 percent to 3 percent.

A long-ago economist summarized it this way: inflation results from "too much money chasing too few goods." Sustained higher inflation rates can't be maintained unless they are supported by excessive money growth.

Where does this faster money growth come from? It comes from the country's super bank, the Federal Reserve. The "Fed" effectively controls how many dollars are printed and released into the economy.

So why are we having higher inflation now? It's actually part of a pattern. Three and four years ago the economy was wobbly with a recession and very slow job growth. A standard tool the Fed uses to perk up the economy is to put more money into consumers' hands. In fact, during much of 2001 and 2002, it increased the money supply by a rapid 10 percent rate.

Some say the Fed's tactic worked because the economy is doing much better now. But on the downside, the Fed's actions meant a lot of dollars chasing after a smaller amount of products and services, so bingo! we have higher inflation. (Also, the Fed's policies contributed to the dollar's decline in value against foreign currencies.)

Fortunately, the Fed is off its money binge, with the money supply now rising at about 5 percent a year. This means we'll probably see the inflation rate moderate in a year or two. But in the meantime, we're paying for the monetary boost of a few years ago with higher prices today. You decide if it was worth it!

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Dr. Mike Walden is a William Neal Reynolds Professor and extension
economist in the Department of Agricultural and Resource Economics of North
Carolina State University's College of Agriculture and Life Sciences. He
teaches and writes on personal finance, economic outlook and public policy.
His You Decide column is provided every two weeks by the Department of
Communication Services. Earlier You Decide columns are available on the Web
at http://www.cals.ncsu.edu/agcomm/writing/walden/decide.htm
Related audio files are at
http://www.ces.ncsu.edu/depts/agcomm/writing/walden/index.html